CHAPTER 2 (FULL) FAll 2010

# CHAPTER 2 (FULL) FAll 2010 - INTRODUCTION TO EXCHANGE RATES...

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2 1 Exchange Rate Essentials 2 Exchange Rates in Practice 3 The Market for Foreign Exchange 4 Arbitrage and Spot Exchange Rates 5 Arbitrage and Interest Rates 6 Conclusions INTRODUCTION TO EXCHANGE RATES AND THE FOREIGN EXCHANGE MARKET

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2 Defining the Exchange Rate Exchange rate (E domestic/foreign ) rhombus4 The price of a unit of foreign currency in terms of domestic currency for immediate purchase. rhombus4 The exchange rate E measures the relative price of one currency in terms of another.
3 Appreciations and Depreciations Definitions rhombus4 If a currency starts to buy more of another currency we say it has appreciated against that currency. rhombus4 If a currency starts to buy less of another currency we say it has depreciated against that currency. It is important to note the definition of the exchange rate, in order to understand which currency appreciates and which depreciates.

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4 Multilateral Exchange Rates The bilateral exchange rate, as seen above, shows the price at which one currency is exchanged for another. rhombus4 In practice, it is possible for one currency to appreciate relative to one currency, while depreciating relative to another. rhombus4 In order to understand the “average” change in the value of a currency, we need to use a multilateral exchange rate.
5 Multilateral Exchange Rates The nominal effective exchange rate (NEER) is calculated as the sum of the trade shares multiplied by the exchange rate changes for each country.

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6 Computing the NEER rhombus4 If the home country trades with countries 1,…,N then the fractional (%) change in NEER relative to the base year is given by finding the trade-weighted average change in each bilateral exchange rate: Multilateral Exchange Rates
7 Example: Using Exchange Rates to Compare Prices in a Common Currency Why are exchange rates useful? rhombus4 Suppose you wish to compare the prices of a good sold in two locations.

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8 Example: Using Exchange Rates to Compare Prices in a Common Currency Lessons rhombus4 When comparing goods and services across countries, we can use the exchange rate to compare prices in same currency terms. rhombus4 Changes in the exchange rate affect the relative prices of goods across countries: square4 Appreciation in the home currency leads to an increase in the relative price of its exports to foreigners and a decrease in the relative price of imports from abroad. square4 A depreciation in the home currency leads to a decrease in the relative price of its exports to foreigners and an increase in the relative price of imports from abroad.
9 Exchange Rate Regimes: Fixed versus Floating To build models that explain observed behaviour,

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